The Taxable Investor's Manifesto. Stuart E. Lucas

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CHAPTER TWO Diversify at the Right Time and in the Right Way

      Most people think of “diversification” as a financial investment strategy – what percent of stocks, bonds, hedge funds, private equity, venture capital, and real assets should comprise an investment portfolio? But before any of us has the opportunity to think about this aspect of diversification, first we have to accumulate wealth. That almost always requires long-term, concentrated investments of effort and capital. This chapter explains how and when to turn concentrated wealth accumulation into cash for potential reinvestment into that diversified portfolio of financial assets.

Most talented, ambitious people start their professional lives with minimal assets, often some debt, minimal earnings, and lots of earning potential. You can think of that earning potential as a large but intangible asset. Over time that intangible asset changes form. Earning potential converts into actual earnings that can be used to eliminate debts and pay living costs. Whatever earnings are left over convert into savings – a tangible asset.

      In addition to receiving salaries, some people are compensated with concentrated ownership in one company through stock, restricted stock, and stock options. Equity in this form can offer great benefits for entrepreneurs, leaders, and managers in growing companies, but it isn't very liquid, and its value will follow the company's fortunes. In other words, it's risky.

      In professions like dentistry, teaching, and many others, where reasonably predictable careers provide reasonably predictable cash flow but little opportunity to “equitize” professional skill, saving cash earnings is the only way to build financial assets and to diversify personal balance sheets. The earlier the saving process begins, the longer the savings can compound and the larger they can grow. Professional athletes, actors, authors, and others whose earnings are lumpy should save particularly heavily during high earning periods because their future earning potential is unpredictable.

Regardless of career path, at early career stages, savings should be earmarked largely for growth in a diversified portfolio of equities. A significant chunk of that savings can and should benefit from being locked into tax-advantaged retirement plans. In a traditional retirement plan, earnings are contributed pretax. Within the plan assets grow tax-free, sometimes for many decades. Only when assets are withdrawn will earned income tax be payable. In “Roth” plans, taxes are paid currently on contributed earnings, but within the plan assets grown tax-free and there is no tax due upon withdrawal.¹ Investing in Roth plans is particularly advantageous when your current tax rate is low and when you expect to have higher earnings in later years that put you in higher tax brackets. Roth plan assets are not only protected from higher future tax brackets, they are also protected from future legislated tax hikes.

As an incentive to save more, many corporations will match their employees' contributions to retirement plans up to a specific level. If your firm offers this benefit, your decision to save more actually earns you extra compensation. It's as close to free money as most of us ever get and it will compound tax-free for decades. Take full advantage of that benefit if it's available.

      Higher earners may need to put some of their savings in taxable accounts because there are caps on how much they can contribute each year to retirement plans. In this way, they not only diversify their assets, they diversify tax rates on the profits generated by those assets. We will delve more deeply into both points later.

      As successful careers develop, the shift from intangible assets to tangible assets accelerates. For those who mostly earn income, or receive dividends from concentrated stock positions, regular addition to savings enables you not only to grow financial assets, it causes you to invest those assets in all kinds of market conditions. Sometimes markets are strong and getting stronger. Sometimes they are about to crack into a bear market. Sometimes you invest near the bottom of the market cycle. Since it is very difficult to optimally time when to add money to financial markets, regular contributions over years and decades lower the risk and add “time diversification.”

      Time diversification is good for another reason. You gain experience managing financial assets, first with small amounts of money and then larger ones. You learn to work with, and to assess, financial advisors. You gain experience evaluating your own attitudes towards risk through market ups and downs. Do you see market downturns as opportunity to buy good assets at lower prices or do they cause you to lose confidence in your financial strategy and in the people you work with to execute it?

      When you own a concentrated position in a business there are several СКАЧАТЬ